2011

OPINION:
Ireland is heading for bankruptcy, which would be catastrophic for a
country that trades on its reputation as a safe place to do business,
writesMORGAN KELLY

WITH
THE Irish Government on track to owe a quarter of a trillion euro by
2014, a prolonged and chaotic national bankruptcy is becoming
inevitable. By the time the dust settles, Ireland’s last remaining
asset, its reputation as a safe place from which to conduct business,
will have been destroyed.

Ireland is facing economic ruin.

While
most people would trace our ruin to to the bank guarantee of September
2008, the real error was in sticking with the guarantee long after it
had become clear that the bank losses were insupportable. Brian
Lenihan’s original decision to guarantee most of the bonds of Irish
banks was a mistake, but a mistake so obvious and so ridiculous that it
could easily have been reversed. The ideal time to have reversed the
bank guarantee was a few months later when Patrick Honohan was appointed
governor of the Central Bank and assumed de facto control of Irish
economic policy.

As a respected academic expert on banking
crises, Honohan commanded the international authority to have announced
that the guarantee had been made in haste and with poor information, and
would be replaced by a restructuring where bonds in the banks would be
swapped for shares.

Instead, Honohan seemed unperturbed by the
possible scale of bank losses, repeatedly insisting that they were
“manageable”. Like most Irish economists of his generation, he appeared
to believe that Ireland was still the export-driven powerhouse of the
1990s, rather than the credit-fuelled Ponzi scheme it had become since
2000; and the banking crisis no worse than the, largely manufactured,
government budget crisis of the late 1980s.

Rising dismay at
Honohan’s judgment crystallised into outright scepticism after an
extraordinary interview with Bloomberg business news on May 28th last
year. Having overseen the Central Bank’s “quite aggressive” stress tests
of the Irish banks, he assured them that he would have “the two big
banks, fixed by the end of the year. I think it’s quite good news The
banks are floating away from dependence on the State and will be free
standing”.

Honohan’s miscalculation of the bank losses has turned
out to be the costliest mistake ever made by an Irish person. Armed
with Honohan’s assurances that the bank losses were manageable, the
Irish government confidently rode into the Little Bighorn and repaid the
bank bondholders, even those who had not been guaranteed under the
original scheme. This suicidal policy culminated in the repayment of
most of the outstanding bonds last September.

Disaster followed
within weeks. Nobody would lend to Irish banks, so that the maturing
bonds were repaid largely by emergency borrowing from the European
Central Bank: by November the Irish banks already owed more than €60
billion. Despite aggressive cuts in government spending, the certainty
that bank losses would far exceed Honohan’s estimates led financial
markets to stop lending to Ireland.

On November 16th, European
finance ministers urged Lenihan to accept a bailout to stop the panic
spreading to Spain and Portugal, but he refused, arguing that the Irish
government was funded until the following summer. Although attacked by
the Irish media for this seemingly delusional behaviour, Lenihan, for
once, was doing precisely the right thing. Behind Lenihan’s refusal lay
the thinly veiled threat that, unless given suitably generous terms,
Ireland could hold happily its breath for long enough that Spain and
Portugal, who needed to borrow every month, would drown.

At this
stage, with Lenihan looking set to exploit his strong negotiating
position to seek a bailout of the banks only, Honohan intervened. As
well as being Ireland’s chief economic adviser, he also plays for the
opposing team as a member of the council of the European Central Bank,
whose decisions he is bound to carry out. In Frankfurt for the monthly
meeting of the ECB on November 18th, Honohan announced on RTÉ Radio 1’s
Morning Ireland that Ireland would need a bailout of “tens of billions”.

Rarely
has a finance minister been so deftly sliced off at the ankles by his
central bank governor. And so the Honohan Doctrine that bank losses
could and should be repaid by Irish taxpayers ran its predictable course
with the financial collapse and international bailout of the Irish
State.

Ireland’s Last Stand began less shambolically than you
might expect. The IMF, which believes that lenders should pay for their
stupidity before it has to reach into its pocket, presented the Irish
with a plan to haircut €30 billion of unguaranteed bonds by two-thirds
on average. Lenihan was overjoyed, according to a source who was there,
telling the IMF team: “You are Ireland’s salvation.”

The deal was
torpedoed from an unexpected direction. At a conference call with the
G7 finance ministers, the haircut was vetoed by US treasury secretary
Timothy Geithner who, as his payment of $13 billion from
government-owned AIG to Goldman Sachs showed, believes that bankers take
priority over taxpayers. The only one to speak up for the Irish was UK
chancellor George Osborne, but Geithner, as always, got his way. An
instructive, if painful, lesson in the extent of US soft power, and in
who our friends really are.

The negotiations went downhill from
there. On one side was the European Central Bank, unabashedly
representing Ireland’s creditors and insisting on full repayment of bank
bonds. On the other was the IMF, arguing that Irish taxpayers would be
doing well to balance their government’s books, let alone repay the
losses of private banks. And the Irish? On the side of the ECB,
naturally.

In the circumstances, the ECB walked away with
everything it wanted. The IMF were scathing of the Irish performance,
with one staffer describing the eagerness of some Irish negotiators to
side with the ECB as displaying strong elements of Stockholm Syndrome.

The
bailout represents almost as much of a scandal for the IMF as it does
for Ireland. The IMF found itself outmanoeuvred by ECB negotiators,
their low opinion of whom they are not at pains to conceal. More
importantly, the IMF was forced by the obduracy of Geithner and the
spinelessness, or worse, of the Irish to lend their imprimatur, and €30
billion of their capital, to a deal that its negotiators privately admit
will end in Irish bankruptcy. Lending to an insolvent state, which has
no hope of reducing its debt enough to borrow in markets again, breaches
the most fundamental rule of the IMF, and a heated debate continues
there over the legality of the Irish deal.

Six months on, and
with Irish government debt rated one notch above junk and the run on
Irish banks starting to spread to household deposits, it might appear
that the Irish bailout of last November has already ended in abject
failure. On the contrary, as far as its ECB architects are concerned,
the bailout has turned out to be an unqualified success.

The one
thing you need to understand about the Irish bailout is that it had
nothing to do with repairing Ireland’s finances enough to allow the
Irish Government to start borrowing again in the bond markets at
reasonable rates: what people ordinarily think of a bailout as doing.

The
finances of the Irish Government are like a bucket with a large hole in
the form of the banking system. While any half-serious rescue would
have focused on plugging this hole, the agreed bailout ostentatiously
ignored the banks, except for reiterating the ECB-Honohan view that
their losses would be borne by Irish taxpayers. Try to imagine the Bank
of England’s insisting that Northern Rock be rescued by Newcastle City
Council and you have some idea of how seriously the ECB expects the
Irish bailout to work.

Instead, the sole purpose of the Irish
bailout was to frighten the Spanish into line with a vivid demonstration
that EU rescues are not for the faint-hearted. And the ECB plan, so far
anyway, has worked. Given a choice between being strung up like Ireland
– an object of international ridicule, paying exorbitant rates on
bailout funds, its government ministers answerable to a Hungarian
university lecturer – or mending their ways, the Spanish have
understandably chosen the latter.

But why was it necessary, or at
least expedient, for the EU to force an economic collapse on Ireland to
frighten Spain? The answer goes back to a fundamental, and potentially
fatal, flaw in the design of the euro zone: the lack of any means of
dealing with large, insolvent banks.

Back when the euro was being
planned in the mid-1990s, it never occurred to anyone that cautious,
stodgy banks like AIB and Bank of Ireland, run by faintly dim former
rugby players, could ever borrow tens of billions overseas, and lose it
all on dodgy property loans. Had the collapse been limited to Irish
banks, some sort of rescue deal might have been cobbled together; but a
suspicion lingers that many Spanish banks – which inflated a property
bubble almost as exuberant as Ireland’s, but in the world’s ninth
largest economy – are hiding losses as large as those that sank their
Irish counterparts.

Uniquely in the world, the European Central
Bank has no central government standing behind it that can levy taxes.
To rescue a banking system as large as Spain’s would require a massive
commitment of resources by European countries to a European Monetary
Fund: something so politically complex and financially costly that it
will only be considered in extremis, to avert the collapse of the euro
zone. It is easiest for now for the ECB to keep its fingers crossed that
Spain pulls through by itself, encouraged by the example made of the
Irish.

Irish insolvency is now less a matter of economics than of
arithmetic. If everything goes according to plan, as it always does,
Ireland’s government debt will top €190 billion by 2014, with another
€45 billion in Nama and €35 billion in bank recapitalisation, for a
total of €270 billion, plus whatever losses the Irish Central Bank has
made on its emergency lending. Subtracting off the likely value of the
banks and Nama assets, Namawinelake (by far the best source on the Irish
economy) reckons our final debt will be about €220 billion, and I think
it will be closer to €250 billion, but these differences are
immaterial: either way we are talking of a Government debt that is more
than €120,000 per worker, or 60 per cent larger than GNP.

Economists
have a rule of thumb that once its national debt exceeds its national
income, a small economy is in danger of default (large economies, like
Japan, can go considerably higher). Ireland is so far into the red zone
that marginal changes in the bailout terms can make no difference: we
are going to be in the Hudson.

The ECB applauded and lent Ireland
the money to ensure that the banks that lent to Anglo and Nationwide be
repaid, and now finds itself in the situation where, as a consequence,
the banks that lent to the Irish Government are at risk of losing most
of what they lent. In other words, the Irish banking crisis has become
part of the larger European sovereign debt crisis.

Given the
political paralysis in the EU, and a European Central Bank that sees its
main task as placating the editors of German tabloids, the most likely
outcome of the European debt crisis is that, after two years or so to
allow French and German banks to build up loss reserves, the insolvent
economies will be forced into some sort of bankruptcy.

Make no
mistake: while government defaults are almost the normal state of
affairs in places like Greece and Argentina, for a country like Ireland
that trades on its reputation as a safe place to do business, a
bankruptcy would be catastrophic. Sovereign bankruptcies drag on for
years as creditors hold out for better terms, or sell to so-called
vulture funds that engage in endless litigation overseas to have
national assets such as aircraft impounded in the hope that they can
make a sufficient nuisance of themselves to be bought off.

Worse
still, a bankruptcy can do nothing to repair Ireland’s finances. Given
the other commitments of the Irish State (to the banks, Nama, EU, ECB
and IMF), for a bankruptcy to return government debt to a sustainable
level, the holders of regular government bonds will have to be more or
less wiped out. Unfortunately, most Irish government bonds are held by
Irish banks and insurance companies.

In other words, we have
embarked on a futile game of passing the parcel of insolvency: first
from the banks to the Irish State, and next from the State back to the
banks and insurance companies. The eventual outcome will likely see
Ireland as some sort of EU protectorate, Europe’s answer to Puerto Rico.

Suppose
that we did not want to follow our current path towards an ECB-directed
bankruptcy and spiralling national ruin, is there anything we could do?
While Prof Honohan sportingly threw away our best cards last September,
there still is a way out that, while not painless, is considerably less
painful than what Europe has in mind for us.

National survival
requires that Ireland walk away from the bailout. This in turn requires
the Government to do two things: disengage from the banks, and bring its
budget into balance immediately.

First the banks. While the ECB
does not want to rescue the Irish banks, it cannot let them collapse
either and start a wave of panic that sweeps across Europe. So, every
time one of you expresses your approval of the Irish banks by moving
your savings to a foreign-owned bank, the Irish bank goes and replaces
your money with emergency borrowing from the ECB or the Irish Central
Bank. Their current borrowings are €160 billion.

The original
bailout plan was that the loan portfolios of Irish banks would be sold
off to repay these borrowings. However, foreign banks know that many of
these loans, mortgages especially, will eventually default, and were not
interested. As a result, the ECB finds itself with the Irish banks
wedged uncomfortably far up its fundament, and no way of dislodging
them.

This allows Ireland to walk away from the banking system by
returning the Nama assets to the banks, and withdrawing its promissory
notes in the banks. The ECB can then learn the basic economic truth that
if you lend €160 billion to insolvent banks backed by an insolvent
state, you are no longer a creditor: you are the owner. At some stage
the ECB can take out an eraser and, where “Emergency Loan” is written in
the accounts of Irish banks, write “Capital” instead. When it chooses
to do so is its problem, not ours.

At a stroke, the Irish
Government can halve its debt to a survivable €110 billion. The ECB can
do nothing to the Irish banks in retaliation without triggering a
catastrophic panic in Spain and across the rest of Europe. The only way
Europe can respond is by cutting off funding to the Irish Government.

So
the second strand of national survival is to bring the Government
budget immediately into balance. The reason for governments to run
deficits in recessions is to smooth out temporary dips in economic
activity. However, our current slump is not temporary: Ireland bet
everything that house prices would rise forever, and lost. To borrow so
that senior civil servants like me can continue to enjoy salaries twice
as much as our European counterparts makes no sense, macroeconomic or
otherwise.

Cutting Government borrowing to zero immediately is
not painless but it is the only way of disentangling ourselves from the
loan sharks who are intent on making an example of us. In contrast, the
new Government’s current policy of lying on the ground with a begging
bowl and hoping that someone takes pity on us does not make for a
particularly strong negotiating position. By bringing our budget
immediately into balance, we focus attention on the fact that Ireland’s
problems stem almost entirely from the activities of six privately owned
banks, while freeing ourselves to walk away from these poisonous
institutions. Just as importantly, it sends a signal to the rest of the
world that Ireland – which 20 years ago showed how a small country could
drag itself out of poverty through the energy and hard work of its
inhabitants, but has since fallen among thieves and their political
fixers – is back and means business.

Of course, we all know that
this will never happen. Irish politicians are too used to being rewarded
by Brussels to start fighting against it, even if it is a matter of
national survival. It is easier to be led along blindfold until the
noose is slipped around our necks and we are kicked through the trapdoor
into bankruptcy.

The destruction wrought by the bankruptcy will
not just be economic but political. Just as the Lenihan bailout
destroyed Fianna Fáil, so the Noonan bankruptcy will destroy Fine Gael
and Labour, leaving them as reviled and mistrusted as their
predecessors. And that will leave Ireland in the interesting situation
where the economic crisis has chewed up and spat out all of the State’s
constitutional parties. The last election was reassuringly dull and
predictable but the next, after the trauma and chaos of the bankruptcy,
will be anything but.

2010

The
Celtic Tiger faces severe challenges. This column argues that the Irish
government’s commitment to absorb the losses of its banking system may
well lead to a Greek-style debt ratio by 2012. It is a test-in-waiting
for the EU, but one that could be solved by a debt for equity swap to
cover the losses of Irish banks.

From basket case to superstar
and back again – or almost. One has to wonder: How did all this happen?
How did an economy where employment doubled and real GNP quadrupled
during the “Celtic Tiger” era from 1990 to 2007, come to have GNP
contract by 17% by late-2009 (with further falls forecast for 2010), the
deepest and swiftest contraction suffered by a western economy since
the Great Depression? The adjustments faced by the nation are monumental
(see Cotter 2009 and Honohan and Lane 2009).

Two booms
The
key to understanding what happened to Ireland is to realise that while
GNP grew from 5% to 15% every year from 1991 to 2006, this Celtic Tiger
growth stemmed from two very different booms. First, the 1990s saw
rising employment associated with increased competitiveness and a
quadrupling of real exports. As Ireland converged to average levels of
western European income around 2000 it might have been expected that
growth would fall to normal European levels. Instead growth continued at
high rates until 2007 despite falling competitiveness, driven by a
second boom in construction. I analyse this second boom, the Irish
bubble, in a recent CEPR Discussion Paper (Kelly 2010).

Credit bubble
Ireland
went from getting about 5% of its national income from house building
in the 1990s – the usual level for a developed economy – to 15% at the
peak of the boom in 2006–2007, with another 6% coming from other
construction. In effect, the Irish decided that competitiveness no
longer mattered, and that the road to riches lay in selling houses to
each other.
However, driving the construction boom was another boom,
in bank lending. As Figure 1 shows, back in 1997 when Ireland’s economy
really was among the world’s best performing, Irish banks lent sparingly
by international standards. Lending to the non-financial private sector
was only 60% of GNP, compared with 80% in Britain and most Eurozone
economies. The international credit boom saw these economies experience a
rapid rise in bank lending, with loans increasing to 100% of GDP on
average by 2008.
These rises were dwarfed, however, by Ireland, where
bank lending grew to 200% of national income by 2008. Irish banks were
lending 40% more in real terms to property developers alone in 2008 than
they had been lending to everyone in Ireland in 2000, and 75% more to
house buyers.
Figure 1. Bank lending to households and non-financial firms as a percentage of GDP (GNP for Ireland), 1997 and 2008.

This
tripling of credit relative to GNP distorted the Irish economy
profoundly. Its most visible impact was on house prices. In 1995 the
average first-time buyer took out a mortgage equal to three years’
average industrial earnings, and the average house cost 4 years’
earnings. By the bubble peak in late 2006, the average first-time buyer
mortgage had risen to 8 times average earnings, and the average new
house now cost 10 times average earnings, with the average Dublin
second-hand house costing 17 times average earnings (see Figures 2 and
3).
As the price of new houses rose faster than the cost of building
them, investment in housing rose. By 2007, Ireland was building half as
many houses as Britain, which has 14 times its population.
The flow
of new mortgages peaked in the third quarter of 2006, and then fell
rapidly. By the middle of 2007 the Irish construction industry was in
clear trouble, with unsold units beginning to accumulate. More than
one-sixth of housing units are now estimated to be vacant.
Figure 2. Irish house prices relative to average industrial earnings, 1980 – 2009

Figure 3. Irish new house prices and first time buyer mortgages relative to average industrial earnings, 1990 – 2009

Banking collapse
This
property slowdown was bad news for an Irish banking system which had
lent, usually without collateral, an amount equal to two-thirds of GNP
to property developers to finance building projects and make speculative
land purchases. Share prices of Irish banks fell steadily from March
2007, with the crisis coming to a head in late September 2008 with a run
in wholesale markets on the joint-second largest Irish bank, Anglo
Irish. After aggressive denials that the banking system faced any
difficulties, the Irish government has been forced to improvise a series
of increasingly desperate and expensive responses.
As well as
guaranteeing the deposits and most bonds of Irish banks, the Irish
government has currently spent, or committed itself to spend, around €40
billion on a National Asset Management Agency to buy non-performing
development loans from banks, and to invest around €30 billion in Irish
banks. Despite this large injection (equivalent to half of GNP), Irish
banks remain moribund.
While the Irish government bailout deals with
bank losses on loans to property developers, it does nothing about their
two other problems: a heavy reliance on wholesale funding; and the
prospect of further large losses on mortgages and business loans.
Half
of Irish bank funding comes from international wholesale markets.
Without continued government guarantees of their borrowing and, more
problematically, continued access to ECB emergency funding, the
operations of the Irish banks do not appear viable. Borrowing in bond
markets at 6% to fund mortgages yielding 3% is not a sustainable
activity, and Irish banks face no choice but to shrink their balance
sheets. Should Irish bank lending return to normal international levels,
our results indicate that property prices will return to an equilibrium
two thirds below peak levels, with larger falls possible in the medium
term as the flow of new lending is curtailed sharply.
The third
problem facing Irish banks is their mortgages. With house prices down by
around 40%, renewed emigration, and unemployment tripled to above 13%,
Irish banks face substantial mortgage defaults. For comparison, in
Florida and Arizona, whose investor fuelled housing bubbles closely
resembled the Irish one, 25% of mortgages are non-performing.
On top
of the continued disintegration of its banking system, Ireland faces two
other problems: unemployment and government deficits. Private sector
employment has fallen by 16%, while the number of males aged 20-24 in
work has halved. The collapse in Irish competitiveness (wages have risen
over 40% relative to its main trading partners since 2000) which cannot
be solved by a devaluation, will frustrate efforts to reverse this
decline.

Debt crisis
Fifteen fat years allowed the Irish
government to cut income taxes, increase spending and still run a budget
surplus. Between 2007 and 2009 however, tax revenue fell by 20%, while
expenditure rose by 9%, moving the state from a balanced budget to a
deficit of 12% of GDP. In contrast to its inept handling of the banking
crisis, the Irish government has moved decisively to reduce expenditure
and increase tax rates, and appears on target to reduce its deficit to
3% of GDP by 2012.
Ireland’s government debt is still moderate. At
the end of 2009 gross debt was 65% of GDP and, after subtracting the
state pension reserve and pre-funded borrowing, net debt was 40% of GDP.
Assuming that deficit targets are not missed too badly, gross debt
should still be under 85% of GDP by the end of 2012.

Conclusions
This
debt would probably be manageable, had the Irish government not
casually committed itself to absorb all the gambling losses of its
banking system. If we assume – optimistically, I believe – that Irish
banks eventually lose one third of what they lent to property
developers, and one tenth of business loans and mortgages, the net cost
to the Irish taxpayer will be nearly one third of GDP.
Adding these
bank losses to its national debt will leave Ireland in 2012 with a
debt-GDP ratio of 115%. But if we look at the ratio in terms of GNP,
which gives a more realistic picture of the Ireland’s discretionary tax
base, this is a debt-GNP ratio of 140% – above the ratio that is
currently sinking Greece. Even if bank losses are only half as large as
we expect, Ireland is still facing a debt-GNP ratio of 125%.
Ireland
is like a patient bleeding from two gunshot wounds. The Irish government
has moved quickly to stanch the smaller, fiscal hole, while insisting
that the litres of blood pouring unchecked through the banking hole are
“manageable”. Capital markets may not continue to agree for long,
triggering a borrowing crisis which will start, most probably, with a
run on Irish banks in inter-bank markets.
Ireland may therefore
present an early test of the EU bailout fund. However, in contrast to
Greece, Ireland’s woes stem almost entirely from its banking system, and
could be swiftly and permanently cured by a resolution which shares the
losses of Irish banks with the holders of their €115 billion of bonds
through a partial debt for equity swap.

OPINION: What will sink us, unfortunately but inevitably, are the huge costs of the September 2008 bank bailout, writesMORGAN KELLY

IT
IS no longer a question of whether Ireland will go bust, but when.
Unlike Greece, our woes do not stem from government debt, but instead
from the government’s open-ended guarantee to cover the losses of the
banking system out of its citizens’ wallets.

Even under the most
optimistic assumptions about government spending cuts and bank losses,
by 2012 Ireland will have a worse ratio of debt to national income than
the one that is sinking Greece.

On the face of it, Ireland’s debt
position does not appear catastrophic. At the start of the year,
Ireland’s government debt was two- thirds of GDP: only half the Greek
level. (The State also has financial assets equal to a quarter of GDP,
but so do most governments, so we will focus on the total debt.)

Because
of the economic collapse here, the Government is adding to this debt
quite quickly. However, in contrast to its inept handling of the banking
crisis, the Government has taken reasonable steps to bring the deficit
under control. If all goes to plan we should be looking at a debt of 85
to 90 per cent of GDP by the end of 2012.

This is quite large for
a small economy, but it is manageable. Just about. What will sink us,
unfortunately but inevitably, are the huge costs of the bank bailout.

We
can gain a sobering perspective on the impossible disproportion between
the bailout and our economic resources by looking at the US. The
government there set aside $700 billion (€557 billion) to buy troubled
bank assets, and the final cost to the American taxpayer is about $150
billion. These sound like, and are, astronomical numbers.

But
when you translate from the leviathan that is America to the minnow that
is Ireland, it would be equivalent to the Irish Government spending €7
billion on Nama, and eventually losing €1.5 billion in the process.
Pocket change by our standards.

Instead, our Government has
already committed itself to spend €70 billion (€40 billion on the
National Asset Management Agency – Nama – and €30 billion on
recapitalising banks), or half of the national income. That is 10 times
per head of population the amount the US spent to rescue itself from its
worst banking crisis since the Great Depression.

Having received
such a staggering transfusion of taxpayer funds, you might expect that
the Irish banks would now be as fit as fleas. Instead, they are still in
intensive care, and will require even larger transfusions before they
can fend for themselves again.

It is hard to think of any
institution since the League of Nations that has become so irrelevant so
fast as Nama. Instead of the resurrection of the Irish banking system
we were promised, we now have one semi-State body (Nama) buying assets
from other semi-states (Anglo) and soon-to-be semi-States (AIB and Bank
of Ireland), while funnelling €60 million a year in fees to lawyers,
valuers and associated parasites.

What ultimately matters for
national solvency, however, is not how much the State invests in its
banks, but how much it is likely to lose. It is alright to invest €70
billion, or even €100 billion, to rescue your banking system if you can
reasonably expect to get back most of what you spent. So how much are
the banks and, thanks to the bank guarantee, you the taxpayer, likely to
lose?

Let’s start with the €100 billion of property development
loans. We’ll be optimistic and say the loss here will be one-third.
Remember, Anglo has already owned up to losing about €25 billion of its
€75 billion portfolio, so we have almost reached that third without
looking at AIB and Bank of Ireland. I think the final loss will be more
than half, but we’ll keep with the third to err on the side of optimism.

Next
there are €35 billion of business loans. Over €10 billion of these
loans are to hotels and pubs and will likely not be seen again this side
of Judgment Day. Meanwhile, one-third of loans to small and medium
enterprises are reported already to be in arrears. So, a figure of a 20
per cent loss again seems optimistic.

Finally, we have mortgages
of €140 billion, and other personal lending of €20 billion. Current
mortgage default figures here are meaningless because, once you agree a
reduction of mortgage payments to a level you can afford, Irish banks
can still pretend that your loan is performing.

Banks in the US
typically get back half of what they loaned when they foreclose, but
losses here could be greater because banks, fortunately, find it hard to
take away your family home. So Irish banks could easily be looking at
mortgage losses of 10 per cent but, to be conservative, we will say
five.

So between developers, businesses, and personal loans,
Irish banks are on track to lose nearly €50 billion if we are optimistic
(and more likely closer to €70 billion), which translates into a bill
for the taxpayer of over 30 per cent of GDP. The bank guarantee may have
looked like “the cheapest bailout in the world, so far” in September
2008, but it is not looking that way now.

Adding these bank
losses on to the national debt means we are facing a debt by late 2012
of 115 per cent of GDP. If we are lucky.

There is more. The
ability of a government to service its debts depends on its tax base. In
Ireland the proper measure of tax base, at least when it comes to
increasing taxes, is not GDP (including profits of multinational firms,
who will walk if we raise their taxes) but GNP (which is limited to
Irish people, who are mostly stuck here). While for most countries the
two measures are the same, in Ireland GDP is a quarter larger than GNP.
This means our optimistic debt to GDP forecast of 115 per cent
translates into a debt to GNP ratio of 140 per cent, worse than where
Greece is now.

And even this catastrophic number assumes that our
economy does not contract further. For the last two years the Irish
economy has not been shrinking, so much as vaporising. Real GNP and
private sector employment have already fallen by one-sixth – the deepest
and swiftest falls in a western economy since the Great Depression.

The
contraction is far from over, to judge from the two economic indicators
I pay most attention to. Redundancies have been steady at 6,000 per
month for the last nine months. Insolvencies are 25 per cent higher than
this time last year, and are rippling outwards from construction into
the rest of the economy.

The Irish economy is like a patient
bleeding from two gunshot wounds. The Government has moved competently
to stanch the smaller, budgetary hole, while continuing to insist that
the litres of blood pouring unchecked from the banking hole are
“manageable”.

Capital markets are unlikely to agree for much
longer, triggering a borrowing crisis for Ireland. The first torpedo,
most probably, will be a run on Irish banks in inter-bank markets, of
the sort that sank Anglo in 2008. Already, Irish banks are struggling to
find lenders to leave money on deposit for more than a week.

Ireland
is setting itself up to present an early test of the shaky EU
commitment to bail out its more spendthrift members. Probably we will
end up with a deal where the European Central Bank buys Irish debt and
provides continued emergency funding to Irish banks, in return for our
agreeing a schedule of reparations of 5-6 per cent of national income
over the next few decades.

To repay these reparations will take
swingeing cuts in spending and social welfare, and unprecedented tax
rises. A central part of our “rescue” package is certain to be the
requirement that we raise our corporate taxes to European levels,
sabotaging any prospect of recovery as multinationals are driven out.

The
issue of national sovereignty has for so long been the monopoly of
republican headbangers that it is hard to know whether ordinary, sane
Irish people still care about it. Either way, we will not be having it
around much longer.

We have long since left the realm of easy
alternatives, and will soon face a choice between national bankruptcy
and admitting the bank guarantee was a mistake. Either we cut the banks
loose, or we sink ourselves.

While most countries facing
bankruptcy sit passively in denial until they sink – just as we are
doing – there is one shining exception: Uruguay. When markets panicked
after Argentina defaulted in 2002, Uruguay knew it could no longer
service its large external debt. Instead of waiting for a borrowing
crisis, the Uruguayans approached their creditors and pointed out they
faced a choice.

Either they could play tough and force Uruguay
into bankruptcy, in which case they would get almost nothing back, or
they could agree to reduce Uruguay’s debt to a manageable level, and get
back most of what they lent. Realising Uruguay’s problems were largely
not of its own making, and that it had never stiffed its creditors in
the past, the lenders agreed to a debt restructuring, and Uruguay was
able to return to debt markets within a few months.

In one way,
our position is a lot easier than Uruguay’s, because our problem is bank
debt rather than government debt. Our crisis stems entirely from the
Government’s gratuitous decision on September 29th, 2008, to transform
the IOUs of Seán FitzPatrick, Dermot Gleeson and their peers into
quasi-sovereign instruments of the Irish state.

Our borrowing
crisis could be solved before it even happens by passing the same sort
of Special Resolution legislation that the Bank of England enacted after
the Northern Rock crisis. The more than €65 billion in bonds that will
be outstanding by the end of September when the guarantee expires could
then be turned into shares in the banks: a debt for equity swap.

We
need to explain that the Irish State has always honoured its debts in
the past, and will continue to do so. However, the State is a distinct
entity from its banks and, having learned the extent of the banks’
recklessness, we now have no choice but to allow the bank guarantee to
lapse and to share the banks’ losses with their bondholders. It must be
remembered that when these bonds were issued they had no government
guarantee, and the institutions that bought them did so in full
knowledge that they could default, and charged an appropriate rate of
interest to compensate themselves for this risk.

Freed of the
impossible bank debt, the Irish State could concentrate on the other
daunting problems left by its decade-long credit binge: unemployment,
lack of competitiveness and indebted households. The banks would be
soundly capitalised and able to manage themselves free of political
interference.

There are two common objections to sharing the
banks’ losses with their bondholders, both of them specious. The first
is that nobody would lend to Irish banks afterwards. However, given that
soon nobody will be lending to Irish banks anyway, this is not an
issue. Either way, the Irish State and banks are facing a period of
relying on emergency funding. After a debt-for-equity swap, Irish banks,
which were highly profitable before they fell into the clutches of
their current “management”, will be carrying little debt, making them
attractive credit risks.

The second objection is that Ireland
would be sued in every court in Europe. Again wrong. Under the EU’s
winding-up directive, the government that issues a bank’s licence has
full power to resolve the bank under its own laws.

Of course,
expecting politicians to sort out the Irish banks is pure fantasy. Like
their British and American counterparts, Irish politicians have spent
too long believing that banks were the root of national prosperity to
understand that their interests are frequently inimical to those of the
rest of the economy.

The architect of Uruguay’s salvation was not
one of its politicians, but a technocrat called Carlos Steneri. The one
positive development in Ireland in recent months is that control of the
banking system has passed from the Government to similar technocrats.

This
transfer did not take place without a struggle – one that was entirely
missed by the media. When Anglo announced they wanted to take over Quinn
Insurance despite the objections of the Financial Regulator,
journalists seemed to view this as just another case of Anglo being
Anglo. They should have remembered that Anglo cannot now turn on a
radiator unless the Department of Finance says so, and what was going on
instead was a direct power struggle between the Financial Regulator and
the Minister for Finance.

Having been forced to appoint a
credible Financial Regulator and Central Bank governor – first-rate
ones, in fact – the Government must do what they say. Were either
Elderfield or Honohan to resign, Irish bonds would straight away turn to
junk.

Now you understand the extraordinary shift in power that
lay behind the seeming non-headline in this newspaper last month:
“Lenihan expresses confidence in regulator”.

The great
macroeconomist Rudiger Dornbusch observed that crises always take a lot
longer to happen than you expect but, once started, they move with
frightening rapidity. Or, as Hemingway put it, bankruptcy happens
“Slowly. Then all at once.” We can only hope that the Central Bank is
using whatever time remains to us as an independent State to devise an
intelligent Plan B – or is it Plan C?

If you thought the bank bailout was bad, wait until the mortgage defaults hit home
November 8, 2010

THE BIG PICTURE: Ireland is effectively insolvent – the next crisis will be mass home mortgage default, writesMORGAN KELLY

SAD
NEWS just in from Our Lady of the Eurozone Hospital: After a sudden
worsening in her condition, the Irish Patient, formerly known as the
Irish Republic, has been moved into intensive care and put on artificial
ventilation. While a hospital spokesman, Jean-Claude Trichet, tried to
sound upbeat, there is no prospect that the Patient will recover.

It
will be remembered that, after a lengthy period of poverty following
her acrimonious divorce from her English partner, in the 1990s Ireland
succeeded in turning her life around, educating herself, and holding
down a steady job. Although her increasingly riotous lifestyle over the
last decade had raised some concerns, the Irish Patient’s fate was
sealed by a botched emergency intervention on September 29th, 2008
followed by repeated misdiagnoses of the ensuing complications.

With
the Irish Patient now clinically dead, her grieving European relatives
face the melancholy task of deciding when to remove her from life
support, and how to deal with the extraordinary debts she ran up in the
last months of her life . . .

WHEN I wrote in The Irish Times
last May showing how the bank guarantee would lead to national
insolvency, I did not expect the financial collapse to be anywhere near
as swift or as deep as has now occurred. During September, the Irish
Republic quietly ceased to exist as an autonomous fiscal entity, and
became a ward of the European Central Bank.

It is a testament to
the cool and resolute handling of the crisis over the last six months by
the Government and Central Bank that markets now put Irish sovereign
debt in the same risk group as Ukraine and Pakistan, two notches above
the junk level of Argentina, Greece and Venezuela.

September
marked Ireland’s point of no return in the banking crisis. During that
month, €55 billion of bank bonds (held mainly by UK, German, and French
banks) matured and were repaid, mostly by borrowing from the European
Central Bank.

Until September, Ireland had the legal option of
terminating the bank guarantee on the grounds that three of the
guaranteed banks had withheld material information about their solvency,
in direct breach of the 1971 Central Bank Act. The way would then have
been open to pass legislation along the lines of the UK’s Bank
Resolution Regime, to turn the roughly €75 billion of outstanding bank
debt into shares in those banks, and so end the banking crisis at a
stroke.

With the €55 billion repaid, the possibility of resolving
the bank crisis by sharing costs with the bondholders is now water
under the bridge. Instead of the unpleasant showdown with the European
Central Bank that a bank resolution would have entailed, everyone is a
winner. Or everyone who matters, at least.

The German and French
banks whose solvency is the overriding concern of the ECB get their
money back. Senior Irish policymakers get to roll over and have their
tummies tickled by their European overlords and be told what good sports
they have been. And best of all, apart from some token departures of
executives too old and rich to care less, the senior management of the
banks that caused this crisis continue to enjoy their richly earned
rewards. The only difficulty is that the Government’s open-ended
commitment to cover the bank losses far exceeds the fiscal capacity of
the Irish State.

The Government has admitted that Anglo is going
to cost the taxpayer €29 to €34 billion. It has also invested €16
billion in the other banks, but expects to get some or all of that
investment back eventually.

So, the taxpayer cost of the bailout
is about €30 billion for Anglo and some fraction of €16 billion for the
rest. Unfortunately, these numbers are not consistent with each other,
and it only takes a second to see why.

Between them, AIB and Bank
of Ireland had the same exposure to developers as Anglo and, to the
extent that they were scrambling to catch up with Anglo, probably lent
to even worse turkeys than it did. AIB and Bank of Ireland did start
with more capital to absorb losses than Anglo, but also face substantial
mortgage losses, which it does not. It follows that AIB and Bank of
Ireland together will cost the taxpayer at least as much as Anglo.

Once
we accept, as the Government does, that Anglo will cost the taxpayer
about €30 billion, we must accept that AIB and Bank of Ireland will cost
at least €30 billion extra.

In my article of last May, when I
published my optimistic estimate of a €50 billion bailout bill, I posted
a spreadsheet on the irisheconomy.ie website, giving my realistic
estimates of taxpayer losses. My realistic estimate for Anglo was €34
billion, the same as the Government’s current estimate.

When you
apply the same assumptions about lending losses to the other banks, you
end up with a likely taxpayer bill of €16 billion for Bank of Ireland
(deducting the €3 billion they have since received from investors) and
€26 billion for AIB: nearly as bad as Anglo.

Indeed, the true
scandal in Irish banking is not what happened at Anglo and Nationwide
(which, as specialised development lenders, would have suffered horrific
losses even had they not been run by crooks or morons) but the
breakdown of governance at AIB that allowed it to pursue the same
suicidal path.

Once again we are having to sit through the same
dreary and mendacious charade with AIB that we endured with Anglo: “AIB
only needs €3.5 billion, sorry we meant to say €6.5 billion, sorry . .
.” and so on until it is fully nationalised next year, and the true
extent of its folly revealed.

This €70 billion bill for the banks
dwarfs the €15 billion in spending cuts now agonised over, and reduces
the necessary cuts in Government spending to an exercise in futility.
What is the point of rearranging the spending deckchairs, when the
iceberg of bank losses is going to sink us anyway?

What is
driving our bond yields to record levels is not the Government deficit,
but the bank bailout. Without the banks, our national debt could be
stabilised in four years at a level not much worse than where France,
with its triple A rating in the bond markets, is now.

As a
taxpayer, what does a bailout bill of €70 billion mean? It means that
every cent of income tax that you pay for the next two to three years
will go to repay Anglo’s losses, every cent for the following two years
will go on AIB, and every cent for the next year and a half on the
others. In other words, the Irish State is insolvent: its liabilities
far exceed any realistic means of repaying them.

For a country or
company, insolvency is the equivalent of death for a person, and is
usually swiftly followed by the legal process of bankruptcy, the
equivalent of a funeral.

Two things have delayed Ireland’s
funeral. First, in anticipation of being booted out of bond markets, the
Government built up a large pile of cash a few months ago, so that it
can keep going until the New Year before it runs out of money. Although
insolvent, Ireland is still liquid, for now.

Secondly, not
wanting another Greek-style mess, the ECB has intervened to fund the
Irish banks. Not only have Irish banks had to repay their maturing
bonds, but they have been haemorrhaging funds in the inter-bank market,
and the ECB has quietly stepped in with emergency funding to keep them
going until it can make up its mind what to do.

Since September, a
permanent team of ECB “observers” has taken up residence in the
Department of Finance. Although of many nationalities, they are known
there, dismayingly but inevitably, as “The Germans”.

So, thanks
to the discreet intervention of the ECB, the first stage of the crisis
has closed with a whimper rather than a bang. Developer loans sank the
banks which, thanks to the bank guarantee, sank the Irish State, leaving
it as a ward of the ECB.

The next act of the crisis will
rehearse the same themes of bad loans and foreign debt, only this time
as tragedy rather than farce. This time the bad loans will be mortgages,
and the foreign creditor who cannot be repaid is the ECB. In
consequence, the second act promises to be a good deal more traumatic
than the first.

Where the first round of the banking crisis
centred on a few dozen large developers, the next round will involve
hundreds of thousands of families with mortgages. Between negotiated
repayment reductions and defaults, at least 100,000 mortgages (one in
eight) are already under water, and things have barely started.

Banks
have been relying on two dams to block the torrent of defaults – house
prices and social stigma – but both have started to crumble alarmingly.

People
are going to extraordinary lengths – not paying other bills and
borrowing heavily from their parents – to meet mortgage repayments, both
out of fear of losing their homes and to avoid the stigma of admitting
that they are broke. In a society like ours, where a person’s moral
worth is judged – by themselves as much as by others – by the car they
drive and the house they own, the idea of admitting that you cannot
afford your mortgage is unspeakably shameful.

That will change.
The perception growing among borrowers is that while they played by the
rules, the banks certainly did not, cynically persuading them into
mortgages that they had no hope of affording. Facing a choice between
obligations to the banks and to their families – mortgage or food –
growing numbers are choosing the latter.

In the last year,
America has seen a rising number of “strategic defaults”. People choose
to stop repaying their mortgages, realising they can live rent-free in
their house for several years before eviction, and then rent a better
house for less than the interest on their current mortgage. The prospect
of being sued by banks is not credible – the State of Florida allows
banks full recourse to the assets of delinquent borrowers just like
here, but it has the highest default rate in the US – because there is
no point pursuing someone who has no assets.

If one family
defaults on its mortgage, they are pariahs: if 200,000 default they are a
powerful political constituency. There is no shame in admitting that
you too were mauled by the Celtic Tiger after being conned into taking
out an unaffordable mortgage, when everyone around you is admitting the
same.

The gathering mortgage crisis puts Ireland on the cusp of a
social conflict on the scale of the Land War, but with one crucial
difference. Whereas the Land War faced tenant farmers against a relative
handful of mostly foreign landlords, the looming Mortgage War will pit
recent house buyers against the majority of families who feel they
worked hard and made sacrifices to pay off their mortgages, or else
decided not to buy during the bubble, and who think those with mortgages
should be made to pay them off. Any relief to struggling
mortgage-holders will come not out of bank profits – there is no longer
any such thing – but from the pockets of other taxpayers.

The
other crumbling dam against mass mortgage default is house prices. House
prices are driven by the size of mortgages that banks give out. That is
why, even though Irish banks face long-run funding costs of at least 8
per cent (if they could find anyone to lend to them), they are still
giving out mortgages at 5 per cent, to maintain an artificial floor on
house prices. Without this trickle of new mortgages, prices would
collapse and mass defaults ensue.

However, once Irish banks pass
under direct ECB control next year, they will be forced to stop lending
in order to shrink their balance sheets back to a level that can be
funded from customer deposits. With no new mortgage lending, the housing
market will be driven by cash transactions, and prices will collapse
accordingly.

While the current priority of Irish banks is to
conceal their mortgage losses, which requires them to go easy on
borrowers, their new priority will be to get the ECB’s money back by
whatever means necessary. The resulting wave of foreclosures will cause
prices to collapse further.

Along with mass mortgage defaults,
sorting out our bill with the ECB will define the second stage of the
banking crisis. For now it is easier for the ECB to drip feed funding to
the Irish State and banks rather than admit publicly that we are
bankrupt, and trigger a crisis that could engulf other euro-zone states.
Our economy is tiny, and it is easiest, for now, to kick the can up the
road and see how things work out.

By next year Ireland will have
run out of cash, and the terms of a formal bailout will have to be
agreed. Our bill will be totted up and presented to us, along with terms
for repayment. On these terms hangs our future as a nation. We can only
hope that, in return for being such good sports about the whole
bondholder business and repaying European banks whose idea of a sound
investment was lending billions to Gleeson, Fitzpatrick and Fingleton,
the Government can negotiate a low rate of interest.

With a
sufficiently low interest rate on what we owe to Europe, a combination
of economic growth and inflation will eventually erode away the debt,
just as it did in the 1980s: we get to survive.

How low is
sufficiently low? Economists have a simple rule to calculate this. If
the interest rate on a country’s debt is lower than the sum of its
growth rate and inflation rate, the ratio of debt to national income
will shrink through time. After a massive credit bubble and with a shaky
international economy, our growth prospects for the next decade are
poor, and prices are likely to be static or falling. An interest rate
beyond 2 per cent is likely to sink us.

This means that if we are
forced to repay the ECB at the 5 per cent interest rate imposed on
Greece, our debt will rise faster than our means of servicing it, and we
will inevitably face a State bankruptcy that will destroy what few
shreds of our international reputation still remain.

Why would
the ECB impose such a punitive interest rate on us? The answer is that
we are too small to matter: the ECB’s real concerns lie with Spain and
Italy. Making an example of Ireland is an easy way to show that bailouts
are not a soft option, and so frighten them into keeping their deficits
under control.

Given the risk of national bankruptcy it
entailed, what led the Government into this abject and unconditional
surrender to the bank bondholders? I have been told that the
Government’s reasoning runs as follows: “Europe will bail us out, just
like they bailed out the Greeks. And does anyone expect the Greeks to
repay?”

The fallacy of this reasoning is obvious. Despite a
decade of Anglo-Fáil rule, with its mantra that there are no such things
as duties, only entitlements, few Irish institutions have collapsed to
the third-world levels of their Greek counterparts, least of all our tax
system.

And unlike the Greeks, we lacked the tact and common
sense to keep our grubby dealing to ourselves. Europeans had to endure a
decade of Irish politicians strutting around and telling them how they
needed to emulate our crony capitalism if they wanted to be as rich as
we are. As far as other Europeans are concerned, the Irish Government is
aiming to add injury to insult by getting their taxpayers to help the
“Richest Nation in Europe” continue to enjoy its lavish lifestyle.

My
stating the simple fact that the Government has driven Ireland over the
brink of insolvency should not be taken as a tacit endorsement of the
Opposition. The stark lesson of the last 30 years is that, while Fianna
Fáil’s record of economic management has been decidedly mixed, that of
the various Fine Gael coalitions has been uniformly dismal.

As
ordinary people start to realise that this thing is not only happening,
it is happening to them, we can see anxiety giving way to the first
upwellings of an inchoate rage and despair that will transform Irish
politics along the lines of the Tea Party in America. Within five years,
both Civil War parties are likely to have been brushed aside by a hard
right, anti-Europe, anti-Traveller party that, inconceivable as it now
seems, will leave us nostalgic for the, usually, harmless buffoonery of
Biffo, Inda, and their chums.

You have read enough articles by
economists by now to know that it is customary at this stage for me to
propose, in 30 words or fewer, a simple policy that will solve all our
problems. Unfortunately, this is where I have to hold up my hands and
confess that I have no solutions, simple or otherwise.

Ireland
faced a painful choice between imposing a resolution on banks that were
too big to save or becoming insolvent, and, for whatever reason, chose
the latter. Sovereign nations get to make policy choices, and we are no
longer a sovereign nation in any meaningful sense of that term.

From here on, for better or worse, we can only rely on the kindness of strangers.

2009

Piling Anglo losses on to national debt risks bankrupting the State
January 20, 2009

ANALYSIS: Anglo
Irish is poisoning the banking system and is of no systemic importance.
It must not be nationalised; it must be allowed to collapse and with it
the developers at the heart of the problem, writesMorgan Kelly

YESTERDAY’S
CATASTROPHIC collapse of Irish bank shares stems directly from the
Government’s proposal to nationalise Anglo Irish Bank. With the
Government’s finances already buckling under the collapse of our bubble
economy, financial markets began to fear that with the added burden of
Anglo’s debt, the Irish State cannot afford to finance itself, let alone
support the remaining national banks.

Facing the imminent
collapse of the national financial system, the Government needs to
perform a ruthless triage. The worthwhile banks need to be maintained by
any means necessary, including nationalisation, while Anglo Irish and
Irish Nationwide must be allowed to collapse.

What began as farce
has turned swiftly to catastrophe. Last September the Government
casually decided to give a small dig-out to some developer pals by
guaranteeing the liabilities of Anglo Irish Bank. This spiralled into a
proposed nationalisation that would saddle Irish taxpayers with Anglo’s
bad debts, which could easily exceed €20,000 per household, and starve
the other, worthwhile, banks of the capital they need to survive.

At
the original crisis meeting on September 29th, Brian Cowen claimed that
the blanket guarantee to all six banks was given “on the basis of the
advice from those who are competent to so advise the Government”.

That does not appear to have been the case.

According
to a source of mine very familiar with what happened at the meeting,
extending the liability guarantee to Anglo Irish and Irish Nationwide
was strongly opposed by representatives of the Central Bank and the
Department of Finance (who reportedly came into the meeting with a draft
Bill to rescue only four institutions). However, I am told they were
overruled by the Taoiseach and the Minister for Finance, who were
supported by the Financial Regulator and the Governor of the Central
Bank on the grounds that a sudden liquidation of Anglo’s assets would
not be in the national interest.

It is still worth asking what
would have happened if Brian Cowen had listened to the Department of
Finance and allowed Anglo Irish to sink? The answer is: very little.

Developers
would have gone bust and commercial property would have become more or
less worthless, but that is going to happen anyway, with or without
Anglo Irish. Depositors of Anglo Irish would have been paid off in full,
and the hit would have been taken by the international financial
institutions that hold around €22 billion of its bonds.

These
bondholders are professional institutional investors who signed up for
higher returns on Anglo debt in the knowledge that they were facing
higher risks. They are, moreover, insured against their losses through
insurance contracts called Credit Default Swaps.

This is the
central point about the bailout of Anglo Irish, and one that has not
received any attention: the only effect of a bailout is that the Irish
taxpayer will make up the losses of Anglo Irish’s bondholders instead of
the insurers who had already been paid to underwrite the risk.

Why
it is necessary to transfer Anglo’s losses from the writers of Credit
Default Swaps to the Irish taxpayer is something that the Government has
not thought to justify.

Indeed, what has been disturbing about
the entire Anglo affair is that at no stage has the Government felt it
necessary to explain why any bailout was needed, beyond inchoate
mutterings about the “systemic importance” of Anglo Irish.

The
reality is that Anglo has no importance in the Irish financial system.
It existed purely as a vehicle for a few politically connected
individuals to place reckless bets on the commercial property market.
These property speculators may be of systemic importance to the finances
of Fianna Fáil, but their significance ends there.

In ordinary
times, piling €30 billion of Anglo Irish losses on to the national debt
would be painful and pointless but not impossible. These however are not
ordinary times. International debt markets are flooded with governments
trying to borrow. The other Irish banks are dangerously short of
capital. Most importantly, the Irish economy and government finances are
collapsing.

Ireland’s growth during the last decade was largely
illusory, generated by a property bubble fuelled by reckless bank
lending. In 2007 an incredible 20 per cent of our national income and
employment came from building houses and commercial property. Next year,
the percentage will be approximately zero.

The only
industrialised economy that has endured a property and banking crash
remotely comparable to what we are beginning to experience was Finland
in 1991, where national income fell in total by 15 per cent and
unemployment rose by 12 percentage points. As the private sector
haemorrhages jobs it is hard to see how Irish national income will fall
by less than 20 to 25 per cent in the next few years. Unemployment will
easily reach 15 per cent by the end of the summer, and 20 per cent by
next year, and will not start to fall until recovery in Britain and
elsewhere permits mass emigration to resume. The economy will not begin
to grow until real wages fall to competitive international levels, a
process that will probably take a decade.

In other words, the
Irish economy is facing a decade of stagnation and mass unemployment of
the same magnitude as the 1980s, with the difference that the unemployed
now have mortgages, car loans and maxed-out credit cards. Faced with an
irreversible contraction on this scale, the Government will have grave
difficulty borrowing to fund its ordinary expenditure, even after
draconian cuts in spending and increases in taxation. In the view of
international investors, piling Anglo Irish’s gambling losses on top of a
spiralling national debt could easily suffice to sink the Irish State
into bankruptcy.

In this national crisis, what should be done?
The answer is simple. The State must do everything to rescue AIB, Bank
of Ireland and Permanent TSB, and let Anglo Irish and Irish Nationwide
sink.

The Government must continue to guarantee all deposits at
Anglo Irish while announcing that, in the light of continuing
revelations of misconduct in the bank and shortcomings in its auditing
procedures, it will enter into negotiations with senior and unsecured
bondholders.

The proposed Anglo nationalisation marks a decisive
watershed in Irish democracy. With it, an Irish government has coolly
looked its citizens in the eye and said: “Sorry, but your priorities are
not ours.”

It is to be hoped that the collapse of other bank
shares will serve as a warning to deter the Government from this
catastrophic course. I would therefore urge any TDs and Senators who
still believe that the Irish State exists to act in the interests of its
people to vote against the nationalisation of Anglo Irish and do
everything to protect the other banks.

Morgan Kelly is professor of economics at University College Dublin.

Corrections & Clarifications - Published January 22nd

In
this article, it was stated that the Minister for Finance Brian Lenihan
had failed to follow advice received from representatives of the
Central Bank and the Department of Finance at a meeting on September
29th 2008 at which the Government decided to guarantee the deposits and
certain identified liabilities of six named financial institutions.

It
was also stated that a Bill to rescue only four institutions was before
the Government on that occasion. In fact, the Bill was the same as that
passed by the Oireachtas this week, being a Nationalisation Bill. The
Irish Times notes the unequivocal statement by the Minister for Finance
in the Dáil on Tuesday confirming the correct factual position and we
are happy to set the record straight and withdraw any suggestion of
corrupt motives on the part of the Minister.

Bank guarantee likely to deal a crippling blow to the economy
February 17, 2009

ANALYSIS: Government borrowing is not an immediate problem, but the extent of banks’ bad debts may prove catastrophic, writesMORGAN KELLY

BETWEEN
COLLAPSING house prices, bankrupt banks and spiralling unemployment,
you might be forgiven for thinking that fate has already dealt Ireland
every misfortune in its hand. However, there may be one more unpleasant
surprise in store for us, the prospect that international investors
unexpectedly stop lending to the Government.

Economists call this
a “sudden stop”. The original sudden stop occurred in 1998 when a
default by Russia panicked lenders away from Latin America and plunged
their economies into prolonged crisis.

The consensus among Irish
economists is that government borrowing is not an immediate problem.
Ireland has a low level of public debt by international standards, and
even a few years of heavy borrowing will still leave it below Greek and
Italian levels.

To understand why this view is too complacent,
imagine that you are a bank manager and somebody that we will call Brian
(not his real name) comes in looking for a loan.

Brian’s income
is €30,000 and he would like to borrow €20,000 to cover living expenses.
This sounds like a lot in these nervous times but, because Brian is not
carrying much debt, you think you might lend to him.

However,
Brian then lets it slip that, because his income is falling sharply, he
will need to borrow at least as much each year for the foreseeable
future. He also admits that, late one night and for what seemed like
good reasons at the time, he somehow agreed to insure the gambling
losses of some “banks”.

Brian has no idea how large these losses
might be, but is starting to fear that they might be substantial. At
this stage, you realise that Brian is on a trajectory into bankruptcy
and show him the door.

Multiply the numbers in this story by a
million and you begin to understand why Ireland makes bond markets
nervous. First, the Irish economy is heading into a severe and prolonged
slump that will force the Government to borrow heavily at a time when
markets are increasingly reluctant to lend heavily.

Secondly, the
Government’s delay in revealing how much its bank liability guarantee
is likely to cost is making markets suspect that the final bill will be
crushing.

After a decade of a credit-fuelled property bubble, the
economy is not so much crumbling as vaporising: were we the size of
Britain, January’s rise in unemployment would have been over half a
million.

As the economy collapses, so does the Government’s tax
revenue. This year the Government will have to borrow about €20 billion –
everything it spends on wages or on social welfare – or about 15 per
cent of a falling national income.

With no chance that the
hopelessly uncompetitive economy will recover in the next five years and
little sign that the Government has any appetite for serious cuts in
spending or increases in taxation, borrowing looks set to continue at
around this level for the foreseeable future.

If this borrowing
was the limit of the Government’s liabilities, Ireland would probably
just about weather the storm in the bond markets. Unfortunately, an
elephant is lurking in the corner in the form of the bank liability
guarantee, and this looks increasingly certain to sink the economy.

In
my view, the Government has made insufficient effort to estimate how
much its banks have lost. We have therefore had the bizarre experience
of nationalising Anglo Irish Bank and recapitalising Allied Irish Banks
and Bank of Ireland without knowing precisely the extent of their bad
debts.

The Government has not updated its estimate of losses
since Brian Lenihan’s boast that the liability guarantee was “the
cheapest bailout in the world so far”, an assurance that already ranks
in the annals of supreme political irony alongside Neville Chamberlain’s
“peace in our time”.

The ability of the State to continue
funding itself ultimately depends on the size of these bad debts. If
they are of the order of €10–€20 billion, we will survive. If they are
of the order of €50-€60 billion, we are sunk.

Irish banks could
easily lose this much. If we suppose that most of the €20 billion lent
to builders will not reappear this side of Judgment Day, along with 20
per cent of the €90 billion lent to developers, and 10 per cent of the
€120 billion in mortgages, then we are already up to €50 billion.

These
are only guesses. However, the continuing stream of revelations from
Anglo Irish – which bear out the old investment dictum that there is
never just one cockroach in a kitchen – suggest that they could be
optimistic guesses.

To see what would happen to Ireland if
foreign lenders suddenly pull the plug, we only need to look at what
happened in Latvia last December. We would be forced to seek an
international bailout, with the International Monetary Fund and European
Union playing bad cop and good cop. We could expect cuts of one-quarter
to one-third in public sector wages and social welfare benefits, and
draconian tax rises to bring the deficit back to around 5 per cent of
national income in two years.

There is actually a worse scenario
where international bond markets suffer a general panic, like 1998. Not
only does Ireland gets torpedoed, but also Portugal, Italy, Greece,
Spain and Austria. The IMF and EU simply would not have the resources to
bail out so many economies and we would be entirely on our own.

In
circumstances where the Government could not even pay public sector
salaries, the bank guarantee would immediately become worthless and we
would see an uncontrollable run on all the Irish banks.

Watching
the ineptitude and complacency of Lenihan’s bank bailout, we can
understand increasingly how the people of New Orleans must have felt as
they watched George Bush rescue their city: “Brianie: you’re doing a
heck of a job.”

Particularly galling are the Government’s efforts
to feign surprise and indignation at the behaviour of the banks, when
the reality is that this is how we have always done business here. All
that the Anglo affair has done is to hold up our grubby brand of crony
capitalism for international ridicule.

For increasing numbers of
ordinary people, the Irish economic miracle has turned out to be as
worthwhile as a share in Bernard L Madoff Investments.

In return
for working hard and paying their taxes, the lucky ones who keep their
jobs can now look forward to pay cuts, negative equity and savage tax
rises; while the unlucky ones face prolonged unemployment and losing
their homes, their cars and everything for which they have worked.

If,
on top of this, we suffer a sudden stop, people will see their pensions
and Government spending slashed to pay off the gambling losses of Seán
FitzPatrick and his pals. The Irish social fabric would certainly rip
and unprecedented civil disorder ensue.

Bill Clinton’s feared
enforcer James Carville once said that he would like to be reincarnated
as the bond market, because that way you get to intimidate everyone.

Without
decisive and intelligent Government action in the next few weeks, by
the end of this year we will understand exactly what he meant.

OPINION: Nama
is in effect Fianna Fáil’s shrine to the property bubble for which the
party still yearns. Prepare to pay 10 per cent more in income tax for
the next 10 years to pay for it all . . . we are headed for national
bankruptcy, arguesMORGAN KELLY

WRITING
HERE two years ago, I pointed out that the exuberant lending of Irish
banks to builders and property developers would sink them if the
property bubble burst. Since then, the bubble has burst, the banks have
sunk, and we are all left wondering how to salvage them.

Two
ideas for fixing the banks have been suggested: a bad bank or National
Asset Management Agency (Nama) and nationalisation. While these
proposals differ in detail, their impact will be identical. Irish
taxpayers will be stuck with a large bill, and in return will get an
undercapitalised and politically controlled banking system.

A far
more efficient and cheaper alternative to Nama is to copy what Barack
Obama did with General Motors, and transfer ownership of Irish banks to
their bond holders. In this way we can achieve well capitalised banks,
run without political interference, at minimal cost to taxpayers.

By
converting a portion of Allies Irish Banks’ approximately €40 billion
of bonds, and Bank of Ireland’s €50 billion, into shares, each
institution can be recapitalised. Transferring ownership to bond holders
will not cost the taxpayer a cent and will avoid interminable legal
battles over the transfer of assets to Nama.

While the shaky
state of Irish banks had been worrying investors since early 2007, when
the crisis finally broke in late September the Government was taken
completely by surprise and reacted with blind panic. Faced with a run on
Anglo Irish Bank by institutional depositors on September 29th, the
Government was stampeded into guaranteeing virtually all liabilities,
except shares, of the six Irish banks.

This guarantee contained
two obvious but fundamental flaws. Everything that has happened since –
the proposed recapitalisation of Anglo, the nationalisation of Anglo,
the establishment of Nama – can be understood as the Government
scrambling to catch up with the consequences of these two errors.

The
first mistake was to guarantee not only deposits – which had to be
guaranteed – but also most of the existing bonds issued by banks to
other financial institutions. Bond holders receive higher returns in the
knowledge that they are accepting the risk of losses on their
investment. In addition, unlike depositors who can scarper, existing
bond holders are effectively stuck.

It made no sense for the
Government to insist that taxpayers would take the hit on any bank
losses instead of the financial institutions that had already entered
legal contracts to do so.

The second mistake was to extend the
guarantee to Anglo Irish and Irish Nationwide. As specialised property
development lenders with incompetent management, they were at risk of
heavy losses as their market collapsed, and fulfilled no role in the
wider economy.

In making the guarantee on September 29th, I do
not doubt that the Government believed that the difficulties of Irish
banks ran no deeper than temporary liquidity problems stemming from the
international crisis. However, as it has become apparent that Anglo was a
mismanaged wreck, with AIB and Bank of Ireland scarcely better, the
Government has stuck with the mantra that all banks are equally
important and equally worth saving at any cost to the taxpayer.

Brian
Lenihan and Brian Cowen are happier to dice with national bankruptcy
than lose face by admitting that they were misled about the state of
Irish banks last September.

Nama, then, is the latest twist in
the Government’s increasingly bizarre efforts to save the Irish banking
system while claiming that it does not really need to be saved.

Underlying
Nama is the delusion that the collapse of our property bubble is a
temporary downturn. In a few years time when the global economy recovers
we will be back building houses like it was 2006. All the ghost
estates, empty office blocks, guest-less hotels and weed choked fields
that Nama has bought on our behalf will once again be worth a fortune.

The
reality is that, because of our surfeit of empty housing, there will be
almost no construction activity for the next decade. Empty apartment
blocks in Dublin will eventually be rented, albeit at rates so low that
many will decay into slums. However, most of the unfinished estates that
litter rural Ireland – where the only economic activity was building
houses – will never be occupied.

Nama is a variant on the “Cash
for Trash” scheme briefly floated in the United States last year where
the government would recapitalise banks by overpaying for their bad
loans. Our Government is proposing to buy €90 billion of loans and will
reportedly pay €75 billion for them.

The International Monetary
Fund (IMF) guesses that Nama will cost us €35 billion, and this is
probably optimistic. The narrowness of the Irish property market meant
that banks effectively operated a pyramid scheme, bidding up prices
against each other. Now that banks cannot lend, development assets are
effectively worthless.

The taxpayer is likely to lose well over
€25 billion on Anglo alone. Among its “assets” are €4 billion lent for
Irish hotels, and almost €20 billion for empty fields and building
sites. In fact, I suspect that the €20 billion already repaid to the
casino that was Anglo represents winners cashing in their chips, while
the outstanding €70 billion of loans will turn out to be worthless. And
it is well to remember, as the architects of Nama have not, that
although the problems of Irish banks begin with developers, they do not
end there.

The same recklessness that impelled banks to lend
hundreds of millions to builders to whom most of us would hesitate to
lend a bucket; also led them to fling tens of billions in mortgages, car
loans, and credit cards at people with little ability to repay. Even
without the bad debts of developers, the losses on these household loans
over the next few years will probably be sufficient to drain most of
the capital out of AIB and Bank of Ireland.

Brian Lenihan’s largesse to bond holders could cost you and me €50 to €70 billion. What do numbers like these mean?

The
easiest way to put numbers of this magnitude into perspective is to
remember that in 2008 the Government generated €13 billion in income
tax. Every time you hear €10 billion, then, think of paying 10 per cent
more income tax annually for the next decade.

In other words, the
fiscal capacity of a state with only two million taxpayers, and falling
fast, is frighteningly thin. Ten billion here, and ten billion there
and, before you know it, you are talking national bankrutcy. Even
without bankrupty, Nama will ensure a crushing tax burden for everyone
in Ireland for decades.

The tragedy is that, were it not for the
Government’s botched efforts to save financiers from the predictable
consequences of their own greed, the Irish economy would have recovered
far more quickly than most people, including the IMF, expect.

Recovery
for the Irish economy will not be easy – there is no painless way for
an economy to move from getting about 20 per cent of its national income
from construction to getting about zero – but the flexibility of the
Irish labour market would have ensured that our incomes and share of
global trade would have rapidly recovered. Now, however, any fruits of
recovery will be squandered on Nama.

Aside from the fact that
Nama will spend huge sums to achieve little, its governance is
problematic. Here, the fog of secrecy that has quietly settled over
Anglo Irish since nationalisation sets an unsettling precedent.

After
revelations of financial irregularities forced the resignation of three
executive directors, Anglo moved decisively to replace them with . . .
Anglo insiders. Most astonishing, in the light of the scandal over Irish
Nationwide deposits, was the decision to replace Anglo’s disgraced
financial director with his immediate subordinate, Anglo’s chief
financial officer.

It is hard not to conclude that a deliberate
decision has been made at the highest level of Government that what
happened in Anglo, stays in Anglo. And we can expect Nama to be run in
the same tight manner.

While there has been considerable
speculation about dark motives for bailing out developers and banks, I
do not believe that the Government’s behaviour has been corrupt: it has
been far worse. At least corruption implies a sense that you are doing
wrong, and need to be paid in return. Our Government actually thought it
was doing the right thing in risking everything to safeguard the
interests of developers who had given us an economy that was the envy of
Europe.

Instead of recognising bankers and developers as
parasites on our national prosperity, the Government came to see them as
its source. While everyone else in Ireland has come to see the past
decade as an embarrassing episode of collective insanity to be put
behind us as soon as possible, the Government still sees it as the high
point of our nation’s history. Nama is effectively Fianna Fáil’s shrine
to the bubble, and likely to be an expensive and enduring one.

What
should be done instead of Nama? First, we need to understand how the
idea of Nama follows from a mistaken analogy with the Swedish banking
crisis and bad bank of the early 1990s. The Swedish banks differed in
one fundamental way from ours: they only had deposits as liabilities. If
their government had not taken over their bad debts, ordinary
depositors would have suffered. By contrast, Irish banks had borrowed
heavily from other financial institutions through bonds, and these
bondholders originally agreed to take losses if Irish banks got into
difficulties.

By placing the costs of the banking collapse
primarily on existing holders of bank bonds, the State can improve its
credit rating and pull back from the edge of bankruptcy. Knowing that
taxpayers are not liable for the losses of AIB and Bank of Ireland will
make capital markets more willing to lend to the Irish State.

Instead,
like a corpulent Tooth Fairy gently slipping billions under the pillows
of sleeping bond holders, Brian Lenihan has chosen to extend the
liability guarantee and further weaken the bargaining position of the
State.

ANALYSIS:
Government estimates of Nama valuations appear implausible, are out of
line with other property collapses and may impose massive losses on the
taxpayer

WHAT HAS been dismaying about the recent acrimonious
exchanges over Nama is that neither side seems to feel it necessary to
produce any evidence to support its assertions about its likely cost to
the taxpayer. Like most discussions in Irish public life, the Nama
debate seems set to generate more heat than light.

If we want to
make sensible predictions on the likely course of Irish property prices
over the next decade, we need to see what has happened historically in
the aftermath of similar booms. In other words, we need to find property
booms where sharp increases in bank lending caused real prices to more
than double.

In Ireland, between 1995 and the peak of the boom in
2007, the average price of housing and commercial property roughly
tripled, adjusting for inflation, while disposable incomes increased by
one half.

Two previous booms fit this pattern closely: Japanese urban land in the 1980s, and Irish agricultural land in the late 1970s.

In
Japan between 1985 and 1990, the real price of commercial land in major
cities tripled, while the price of residential land doubled. What makes
the Japanese case particularly relevant to Ireland, as I pointed out
here two years ago, is that at the peak of their bubble, Japanese banks
had the same extreme exposure to development and construction loans – 30
per cent of their lending – as Irish banks did in 2007.

As
Japanese banks buckled under bad property debts, lending fell sharply
and prices with it. By 2005 – 15 years after the peak – residential land
had fallen back to its pre-bubble level, while commercial land had
fallen by nearly 90 per cent. Given that many people are claiming that
Irish property prices will recover once the economy starts to grow
again, it is interesting to note that Japanese property prices collapsed
while the economy continued slowly to expand: real output in Japan rose
20 per cent between 1990 and 2007 and did not fall in any year during
this period.

The next case is much closer to home but almost
forgotten: the boom and bust in Irish farmland prices in the late 1970s.
After joining the EEC in 1973, Irish banks began to lend heavily to
farmers. As a result, the inflation adjusted price of agricultural land
tripled between 1975 and 1977, reaching a peak equivalent to €14,000 per
acre in 2009 prices. Real Irish GNP in 1977 was about one third of its
present level, so this price is roughly equivalent to €50,000 per acre
in current purchasing power for land with no development potential. For
comparison, during the recent boom, when agricultural land prices were
driven by demand for potential development, prices peaked in 2006 at an
average of €21,000 per acre nationally.

The bubble quickly burst
as farmers ran into difficulties servicing loans: between 1977 and 1980
real prices fell by around 75 per cent, and remained at this level, more
or less where it had started in 1973, until 1995, 18 years after the
peak.

These examples illustrate a general principle: property
bubbles are the consequence of abnormal levels of bank lending. Once the
bank lending that fuelled the boom returns to its usual levels, prices
return roughly to where they started before the boom.

In ordinary
times, property prices grow at the same rate as national income: people
in industrialised economies spend much the same fraction of their
income on housing as they did a century ago.

However, a surge in
prosperity, which drives property prices higher and encourages banks to
lend more on appreciating assets, can lead to a self-reinforcing cycle
of rising prices and rising lending.

Eventually, banks get a
fright and return to levels of lending they used to regard as prudent,
causing prices to fall back to where they were before the bubble. Just
like Irish farmland in the 1970s, and Japanese property in the 1980s,
our recent property boom was the product of unsustainable bank lending.

Between
2000 and 2007, while nominal GNP rose by 77 per cent, mortgage lending
rose from €24 billion to €115 billion, lending to builders from €2.4
billion to to €25 billion, and to developers from €5 billion to €80
billion. Should the usual post-bubble correction occur in Ireland, it
would suggest that real prices of residential and commercial property
would return to their levels of the mid-to-late 1990s, two thirds below
peak values.

Already the Irish property market has seen unusually
sharp falls by international historical standards. The Sherry
FitzGerald house price index is down 35 per cent nationally, and 42 per
cent for Dublin; while the Society of Chartered Surveyors estimate that
commercial property prices have fallen 48.6 per cent from their peak;
and Knight Frank estimate that farmland prices, which were driven by
their development potential, are down 45 per cent from their peak but
are still twice those of comparable UK land.

Despite these large
falls, which already exceed the one third haircut on Nama assets
rumoured to be proposed by the Government, the property market remains
moribund. Property transactions, measured by stamp duty receipts, are
two thirds down on this time last year, and 80 per cent lower than two
years ago.

In other words, if nobody is buying despite large
falls in price, then price needs to fall considerably further to reach
its long-run equilibrium.

The impression that Irish property
prices are still considerably above long-term value is reinforced by
rental yields: the ratio of the rent you get from a property to the
price you paid for it. As many of you have discovered to your cost,
property is a risky asset that performs particularly badly during
economic downturns. To compensate for this fundamental risk, property
should earn a long run rental return of at least 8 per cent.

Despite
some of the highest rents in the world at the peak of the bubble
(according to Lisney, Dublin ranked as the second most expensive
location for industrial property and ninth for offices, with Grafton
Street coming in as the fifth most expensive retail street on earth),
new residential and commercial property was earning a paltry rental
yield of 3-4 per cent.

This means that, to restore long-run equilibrium, prices needed to halve from peak levels, or rents to double.

Suppose
for a moment that the Government’s assertions are correct, and the
long-run value of Irish property is two thirds of its peak value. In
order for rental yields to rise from an unsustainable 4 per cent to a
long-run equilibrium of 8 per cent, the Government needs rents to rise
one third from their already extreme peak values.

In fact,
instead of rising, rents have fallen, and nearly as sharply as prices.
The Irish Property Watch website estimates that residential rents have
fallen by 32 per cent since May 2008; while Lisney estimate that
commercial rents have fallen 24 per cent from peak, with office rents
down 35 per cent and now lower than they were a decade ago.

Again,
these large falls have not been sufficient to restore equilibrium. The
number of rental properties listed on Daft.ie has risen from 5,000 at
the start of 2007 to nearly 25,000 now, while the average time to rent a
property is now 76 days.

For offices, HWBC estimate that
lettings are running at one fifth of their rate last year; while Lisney
calculates that one fifth of Dublin offices are now empty (something
they describe as “startling”) and one third in west Dublin.

The
usual post-bubble correction in property prices is likely to be
aggravated in Ireland’s case by large falls in national income, and the
dislocation in the banking system and Government finances, caused by the
collapse of our unusually large construction boom.

The effective
ending of new construction activity, collapsing consumption, rising
taxes and cuts in Government spending all make the 15 per cent
contraction in GNP forecast by the ESRI and others look optimistic. The
fall in national competitiveness and likely continuing difficulties in
the banking sector make the prospect of a swift national recovery seem
problematic.

What we have seen then is that as the abnormal
lending that fuelled the property boom returns to its normal level,
Irish property prices should fall back to their pre-bubble values, at
around one third of their peak values.

In the absence of evidence
to support it, the Government’s claim that €90 billion in developer
loans are backed by €120 billion in assets appears implausible. While
five-year developer loans were the norm, properties were usually flipped
on after two years, meaning that existing loans were mostly taken out
at peak prices.

In addition, while loans were supposedly 70 per
cent of property value, the collateral supplied was usually equity in
other property or personal guarantees, both now worthless.

It
appears, therefore, that, by paying an average of two thirds of the face
value for Nama assets, the Government is likely to impose severe losses
on taxpayers of the order of €30 billion, or one fifth of national
income.

Morgan Kelly is professor of economics at University
College Dublin. During the recent High Court case involving the Zoe
group of companies and ACCBank, he gave property valuation estimate
evidence on behalf of the bank

Turning bank debt into equity will save us from Nama ruin
October 13, 2009MORGAN KELLY

History
shows Nama-style bad banks are profoundly corrupt and corrupting
institutions. If Nama didn’t happen, the alternative would involve
minimal cost to the taxpayer and banks would manage their business
without political interference

WHILE MOST economists by now
simply dismiss Brian Lenihan’s utterances on the economy as “not even
wrong”, this is to miss the Minister’s almost eerie ability to predict
exactly the opposite of what is going to happen. Merely to contradict
Brian Lenihan is virtually to guarantee that you will later be credited
with supernatural prescience.

Who else, as Irish bank shares
plunged 13 months ago, could conclude: “Our banks uniquely have
weathered this storm . . . We are in a zone of financial stability in a
very troubled financial world.”? Two weeks later, having been panicked
into his catastrophic bank liability guarantee, the Minister assured us
that we had “the cheapest bailout in the world so far”, and six weeks
later averred that: “It is not the function of the Government to fund or
bail out the banks.”

The effortless miscalculations, the assured
non sequiturs, the lofty indifference to facts: all reveal Brian
Lenihan as a master of what Princeton philosopher Harry Frankfurt
defined succinctly in his 1986 paper, On Bullshit .

The Nama
legislation, as expected, piles up this material on an Augean scale.
Prices have fallen 47 per cent; the long-term economic value of property
is 30 per cent below its peak value; the loan-to-value ratio is 77 per
cent; prices only need to rise by 10 per cent in 10 years for the State
to break even.

To subject these almost poetic flights of
ministerial imagination to any sort of rational analysis will seem to
many like vandalism, but that is what God made economists for.

First,
the estimate that prices have fallen 47 per cent. The reality is that
prices can only exist when there is a market, and the market for
commercial property and development land has disappeared.

A less
futile exercise is to ask how much Nama would have cost at the end of
similar credit-fuelled price bubbles. A decade after their peaks, Tokyo
land prices had fallen by five-sixths, while Irish farmland, adjusted
for inflation, had fallen by three-quarters. Had Brian Lenihan bought
€77 billion of either, applying the proposed Nama discount of 30 per
cent, he would have lost €35 billion-€40 billion on our behalf, or
roughly €20,000 per taxpayer, and that is before adding interest.

At
a quarter of national income, Nama would dwarf the cost of previous
bank bailouts, which varied from about 3 per cent of GDP in Sweden to 14
per cent in Finland and Japan.

Most baffling of all the Nama
numbers is the proposed discount of 30 per cent, implying that the
“long-term economic value” of property is at 2004 prices. Not one shred
of evidence is offered for this assertion, the keystone of the
Government’s strategy.

At first, I thought that this mystical 30
per cent number embodied Fianna Fáil nostalgia for a vanished era of
innocent greed; a hope that we would wake up one morning and find
ourselves back in 2004 forever, basking in the benevolent gaze of Bertie
Ahern and Seán FitzPatrick. The reality turns out to be a lot more
mundane. The EU simply forbade Lenihan to pay any more. This is not
through any dismay at seeing Irish taxpayers fleeced by their
Government, but for fear that they will be stiffed into carrying out an
Iceland-style rescue here.

The figure of a 77 per cent
loan-to-value ratio is equally fanciful. It will take years for the
courts and Fraud Squad to disentangle multiple personal guarantees and
imaginary collateral. The situation in Anglo Irish Bank appears
particularly grave.

Finally, there is the assumption that the
Irish Government can continue to borrow forever at low rates from the
European Central Bank. However, the ECB is making no secret of its
dismay at being turned into a credit union for feckless Micks, and is
anxious to end such emergency lending facilities within the next year.

Once
the ECB slams the window on its fingers, the Government will be forced
to borrow at market rates of 5 per cent or more. In the next decade,
this will add another €25 billion or so to taxpayers’ losses from Nama.

Property
speculation was a mania that swept every level of Irish society, from
hairdressers buying apartments in Bulgaria to dentists taking out second
mortgages to join commercial property syndicates. Business owners were
not immune to the lure of effortless wealth, and many borrowed heavily
to gamble in property.

As one banker put it: “We are happy to
restore their credit line as soon as they repay us the €15 million they
borrowed to buy that land bank on the edge of town.” The destruction of
the Irish commercial class, who we might have hoped to be an engine of
export led recovery as they were in the 1990s, is likely to prove one of
the most enduring and costly legacies of the property bubble.

Forcing
banks to lend to SMEs will only compound our problems. One condition of
the Japanese bank recapitalisation in 1999 was that they lend to small
firms, but the effect was to heap a second layer of non-performing loans
onto existing property losses.

As well as being expensive,
history shows Nama-style bad banks to be profoundly corrupt and
corrupting institutions. After the financial crisis in 1931, the US,
Germany and Austria all set up bad banks which turned into conduits for
directing funds to politically connected enterprises.

Bad banks
are the means for governments to choose which oligarchs will survive to
emerge even stronger than before. They do not just happen to behave in a
corrupt and anti-democratic manner: it is what they are designed to do.

And
do not forget that, even after the crushing expense of Nama, Irish
banks will still be seriously short of capital. Under the current,
deliberately lax, international bank regulations, AIB and Bank of
Ireland need capital of around €8.5 billion.

Financial markets,
which assume that Nama will go through, value their existing capital at
around €3 billion, and adding Government preference shares of €3.5
billion leaves them short about €2 billion each. Once stricter capital
requirements are imposed next year (the so-called Basel 3 process), this
shortfall will probably rise to €6 billion.

Nama then, will turn
out to be expensive, corrupting, and inadequate. While the abject,
almost endearing, eagerness of the Greens to please their Fianna Fáil
masters means Nama is almost certain to go ahead, it is perhaps worth
asking what would happen if it did not.

All that needs to be done
is for ownership of Irish banks to be transferred to their bondholders.
This process of converting debt into equity occurs sufficiently often
in banking to have a name: resolution. Resolution offers a way for Irish
banks to be adequately recapitalised at no cost to the taxpayer, and
able to manage their business without political interference.

Under
existing Irish corporate law, this transfer would be a recipe for
centuries of litigation. That is why most other industrialised economies
have, or are introducing, special legislation to resolve failing banks
with limited judicial review. Particularly impressive is the UK’s
Special Resolution Regime introduced last February, which could easily
serve as a template for similar legistlation here.

Instead we
will get Nama. Brian Lenihan assures us that Fianna Fáil’s monument to a
decade of waste, corruption, and ultimate ruin will not be wasteful,
corrupt, and ultimately ruinous.

Ghosts of debt and jobs will haunt economy
December 29, 2009MORGAN KELLY

OPINION : By 2015, Iceland will almost certainly be a lot better off than Ireland because it dealt decisively with its banks

WHILE
THINGS are hard to predict, the future, especially the situation of the
Irish economy, is so stark that even an economist can make some
predictions that stand a chance of being right.

Two ghosts of Christmas will haunt Ireland in 2015: jobs and debt.

For
20 years, the Irish economy experienced extraordinary growth.
Unfortunately, this growth came from two separate booms that merged
imperceptibly into each other. First we had real growth in the 1990s,
driven by rising competitiveness and exports. However, after 2000
competitiveness collapsed, and growth came to be driven by a lending
bubble without equal in the euro zone.

As Michael Hennigan of Finfacts (http://www.finfacts.ie)
has pointed out, of the half million jobs created in the last decade,
only 4,000 were in exporting firms; and fewer people now work in
IDA-supported companies than in 2000. The Irish economy has been faking
it for a decade.

Now that the property bubble has burst, people
hope that exports will once again become the engine of our salvation.
The problem is that, back when we were becoming rich by selling houses
to each other, we priced ourselves out of world markets. Wages have
risen by one-third here compared with Germany since 2000. Restoring
competitiveness will be an arduous task where nobody, outside the banks
and ESB, will see a pay rise for a decade, and many will take pay cuts.

Whether
desirable or otherwise, leaving the euro is not possible for a mundane
reason. Changing currencies takes a lot of organisation, as we saw when
the euro was introduced. If the Government announced that a New Irish
Pound will be introduced in 12 months, everyone would rush out to
withdraw their savings in euro and wipe out the banks.

Prolonged
mass unemployment is a disaster not only for its victims, but for all
society. The great Harvard sociologist William Julius Wilson showed how
the disappearance of low-skilled jobs in the US during the 1970s led to
the social collapse of black ghettos.

In Ireland for the last 20
years we saw this process working in reverse, as rising employment
turned what had been sink estates into decent, if not wonderful, places
to live. Finding a job does more for the disadvantaged than a legion of
social workers: people’s sense of self-worth is transformed by being
able to earn the money to do ordinary things like own a car, buy toys
for their kids at Christmas, and take their family on holiday.

While
many commentators argue that the benefits of the Celtic Tiger flowed
exclusively to the wealthy and connected, this is nonsense. The benefits
went overwhelmingly to ordinary people in the form of something that
Ireland had never seen before: abundant jobs. By 2015 we will have seen
what happens when jobs disappear forever, particularly from less
educated men who were able to earn a good living in construction. In
effect, Ireland is at the start of an enormous, unplanned social
experiment on how rising unemployment affects crime, domestic violence,
drug abuse, suicide and a litany of other social pathologies.

We
will be forced to discover the consequences when people, who had worked
hard to make decent lives for themselves and their children, find
themselves reduced to nothing. Less than nothing in fact because, unlike
the unemployed in the past, people now losing jobs are weighed down
with debt and facing the terrifying prospect of losing their homes.

Debt
will be the second ghost of Christmas 2015. Back in 1997, when exports
drove real growth, Irish banks lent little by international standards.
By 2008, Ireland had twice as much debt for its size as the average
industrial economy: banks were lending a third more to property
developers alone than they had been lending to everyone in Ireland in
2000.

It was this tidal wave of credit that inflated house prices
and launched the construction boom that drove wages and government
spending to unsustainable levels.

To fund this suicidal lending,
Irish banks borrowed heavily internationally, and now must pay it back
fast as the world realises that our recent economic miracle was less in
the spirit of Adam Smith than of Bernard Madoff. As Irish bank lending
returns to ordinary international levels, property prices will fall by
at least two-thirds from their peaks.

However, five years from
now, property prices could have been driven far lower than that by a
deluge of sales of unsold, foreclosed and abandoned homes.

Mass
mortgage defaults caused by unemployment and falling house prices are
the next act of the Irish economic tragedy. As well as bankrupting our
worthless banks all over again, the human cost of tens of thousands of
families losing their homes will be enormous but, because the Government
has already exhausted the State’s resources taking care of developers
with Nama (National Asset Management Agency), there is very little that
can be done to help these people.

Most people, of course, will
not lose their jobs and homes. However, even they will be forced
painfully to relearn something our parents already knew: beyond a small
mortgage, debt swiftly turns into pure poison that will eat away your
prosperity and happiness.

One response to large-scale home
repossessions that will be attempted is to buy ghost estates for public
housing to accommodate evicted home owners, providing ample
opportunities for good old fashioned petty corruption.

For grand
corruption, though, we will have to look to Nama. By allowing the banks
to dictate the terms of their bailout, the bank rescue was turned into
the most lucrative and audacious Tiger Kidnapping in the history of the
State, with the difference that, like the sheriff in Blazing Saddles ,
the bankers held themselves hostage.

Bad banks like Nama were
tried on a large scale in the early 1930s in the US, Austria and
Germany; and proved to be profoundly corrupt and corrupting
institutions, whose primary purpose was to funnel money to politically
connected businesses. The German bank is best remembered for setting up
what we would now call a special purpose vehicle to fund the
presidential election campaign of the odious Paul Hindenberg.

Bad
banks do not just happen to be corrupt and anti-democratic
institutions, it is what they are designed to be. Effectively, bad banks
give governments the power to choose which of a country’s most powerful
oligarchs will be forced into bankruptcy, and which will be
resuscitated to emerge even more powerful than before.

Nama will
get to pick which of the fattest hogs of Irish development will be
sliced up and fed, at taxpayer expense, to better connected hogs
(remember that Nama has been allocated at least €6.5 billion,
considerably more than the Government saved by draconian budget cuts, to
“lend” to favoured clients).

While Nama may have momentous
political consequences, it has already failed economically: the Irish
banks are still zombies, reliant on transfusions of European Central
Bank funding to survive until losses on mortgages and business loans
finally wipe them out. In the next few months we will discover if the
State bankrupts itself by nationalising the banks; or if it has the
intelligence to free itself from bank losses by turning the foreign
creditors of banks into their owners, as Iceland has just done with
Kaupthing bank.

It is ironic that by 2015, having devalued its
currency and dealt decisively with its banks, Iceland will almost
certainly be a lot better off than Ireland.